Suppose that shareholders are contemplating making an investment today (at t=0) and are considering different financing alternatives. The payoffs on this investment occur one period from today (at t=1). At t=1, only two states of the world (loss and no loss) may occur with equal probabilities. If the loss occurs, the investment will be worth $2,000, and if there is no loss, then the firm will be worth $4,000. However, the firm has an option to rebuild the asset at a cost of $1,600 should a loss occur. Assume that shareholders are risk neutral, the interest rate is zero and bankruptcy is costless.
A. What is the net present value of rebuilding the asset?
B. Suppose the firm is all equity financed. Will shareholders rebuild the asset in the event of a loss? Why or why not?
C. Suppose that as an alternative to equity financing, shareholders can issue zero coupon bonds. If the promised payment on the bonds equals $2,000, will shareholders rebuild the asset in the event of a loss? Why or why not?
D. Suppose shareholders issue zero coupon bonds and promise to repay $3,000 at t=1. With this type of financing arrangement, will shareholders rebuild the asset in the event of a loss? Why or why not?
E. Suppose that instead of issuing zero coupon bonds with a promised repayment of $3,000, shareholders decide to issue zero coupon bonds with a promised repayment of $2,600 and purchase an actuarially fair insurance policy with a deductible of $1,400. With this type of financing arrangement, will shareholders rebuild the asset in the event of a loss? Why or why not?